Fiscal Policy in a Tractable Liquidity-Constrained Economy

61 Pages Posted: 19 Oct 2010

See all articles by Edouard Challe

Edouard Challe

Ecole Polytechnique

Xavier Ragot

National Center for Scientific Research (CNRS)

Date Written: October 1, 2010


In this paper, we analyse the effects of transitory fiscal expansions when public debt is used as liquidity by the private sector. Aggregate shocks are introduced into a tractable flexible-price, incomplete-market economy where heterogenous, infinitely-lived agents face occasionally binding borrowing constraints and store wealth to smooth out idiosyncratic income fluctuations. Debt-financed increases in public spending facilitate self insurance by bond holders and may crowd in private consumption. The implied higher stock of liquidity also loosens the borrowing constraints faced by firms, thereby raising labour demand and possibly the real wage. Whether private consumption and wages actually rise or fall ultimately depends on the relative strengths of the liquidity and wealth effects that arise following the shock. The expansionary effects of tax cuts are also discussed.

Keywords: Borrowing constraints, public debt, fiscal policy shocks

JEL Classification: E21, E62

Suggested Citation

Challe, Edouard and Ragot, Xavier, Fiscal Policy in a Tractable Liquidity-Constrained Economy (October 1, 2010). Banque de France Working Paper No. 297, Available at SSRN: or

Edouard Challe (Contact Author)

Ecole Polytechnique ( email )

Ecole Polytechnique
Department of Economics
Paris, 75005

Xavier Ragot

National Center for Scientific Research (CNRS)

3, rue Michel-Ange
Paris cedex 16, 75794

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